THETRADETECH DAILY
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How to effectively trade at low participation rates while utilising dark block liquidity
Gareth Exton , head of EMEA execution and quantitative services distribution at Liquidnet , explains how combining low participation rate algo strategies such as VWAP and POV with Liquidnet Smart Blocks can help traders realise the benefits of dark block liquidity .
European buy-side traders are increasingly voicing frustration about feeling pushed to trade at low participation rates via strategies like volume weighted average price ( VWAP ) and percentage of volume ( POV ), whilst also keen to utilise dark block liquidity .
Traders and investment firms use these strategies for a variety of reasons including the lack of clarity on price direction , as well as fear of market impact and being adversely affected by the price of a dark block . On top of this , increased volatility seen since the start of the pandemic has led some to ‘ trade the average ’ in anticipation of being caught on the wrong side of price moves , which can increase the opportunity cost and timing risk through longer order durations . Increasing order durations might be ok when there is no alpha present in the order , such as for a CRB desk with a neutral alpha unwind , however , for most buy-side traders this is not the case and managing for momentum is crucial . Using low participation rate strategies while utilising dark block liquidity therefore is challenging but is there a way to do it effectively ?
The use of low participation rate strategies such as VWAP and POV in the market is significant . The recent algorithmic survey compiled by The TRADE in spring 2021 showed 59 % of respondents cited using VWAP and 57 % using POV 1 . Other industry reports have shown that approximately 50 % of algo strategy usage in the market today is also through these strategies 2 .
As well as contending with increased volatility , traders ’ ability to forecast appropriate price levels at which to potentially change trading strategy has been partly hindered by changes in market microstructure . Overall market volumes have reduced but , more importantly , where specific volumes are found
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in the market has changed . For example , composite lit continuous volumes are down from 73 % of total market volumes in July 2016 to 58 % in April 2021 3 , a 20 % reduction in the liquidity that VWAP and POV algos typically interact with when creating their trading schedule and reacting to being ahead or behind of that schedule . In addition , the closing auction has become an even larger part of any VWAP calculation , making the proportion of any order traded during the continuous session even lower . In contrast , overall dark trading volumes have returned to pre-MiFID II levels 4 and dark liquidity has become blockier in nature , with ~ 40 % of dark principal now above LIS 5 .
Tapping into dark liquidity helps traders reduce their trading costs , as cited in a recent FCA paper looking at the effect of banning dark pools . The paper showed better performance vs . the arrival price ( implementation shortfall ) for orders with a larger proportion of executions in venues with lower pre-trade transparency levels such as in dark pools 6 . This is also evident in the savings Liquidnet clients have made through trading blocks , as seen in our ‘ Value of the Block ’ analysis . Clients saved on average 19.7bps of market impact and spread costs on executions in
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